Firms Respond to Demand for Tax Efficiency

Mutual fund companies are taking steps to attract a share of the small but growing group of mutual fund investors who want tax-efficient funds.

Putnam Investments of Boston will begin on Friday to offer a novel tax-efficient fund - the Putnam Tax-Smart Equity Fund - the first product in what Putnam officials say will be a family of tax-efficient funds the company plans to offer. Pioneer Investment Management of Boston also filed a registration statement with the SEC on Sept. 16 for a new fund, the Pioneer Tax Managed Fund.

The moves come as Congress, the SEC and the industry itself increasingly focus on the tax-efficiency of mutual funds and how well that tax efficiency is disclosed to investors. The interest of investors in tax efficient funds appears to be growing as well.

Financial Research Corp. of Boston, a mutual fund tracking and consulting firm, reports sales of tax-managed funds increased dramatically in the first six months of this year. Through July 31, tax-managed funds had net sales of $3.5 billion. For all of 1997, the funds had net sales of only about $1.9 billion. Market share of new sales has increased from 0.71 percent in 1997 to 3.19 percent through July 31, according to FRC.

"I think that these funds will do well in the long term" in attracting assets, said Raymond Liberatore, an analyst at FRC.

There will be more tax-efficient funds and the demand for the product is likely to grow, Liberatore said. In addition, non-tax managed equity funds will be driven by competitive pressures to provide greater tax efficiency in the future, Liberatore said.

Some of that pressure for tax efficiency may come from Congress. Rep. Paul Gillmore (R-Ohio) has proposed legislation that would require funds to disclose the tax consequences of portfolio turnover on performance. The SEC and the industry are grappling with how to make tax disclosure meaningful. (MFMN 9/20/99)

Putnam executives expect to see more demand for tax-efficient products. In addition to the new Putnam Tax-Smart Equity Fund, Putnam expects to offer additional funds that are tax efficient. Possible new funds include a large capitalization value fund, a large capitalization growth fund, a large capitalization international fund and a domestic small capitalization fund, said Howard Present, a managing director at Putnam.

"We believe in the category [of funds]," Present said. "We'd like to see the category expand."

Of the roughly 30 tax-managed funds tracked by FRC, Putnam's Tax-Smart Equity Fund has what appears to be a unique twist. Putnam's goal is to keep the fund's unrealized capital gains to no more than 25 percent of the fund's net asset value. If the fund's unrealized gains start to exceed that level or the fund grows too large, Putnam plans to close the fund and open a new fund with the same investment and tax strategies, Present said. Industry observers could identify no similar strategy among other tax-efficient funds.

Usually, investors who buy shares in a fund after it has grown must pay taxes on a fund's capital gains even though they did not have the benefit of the fund's previous performance. Putnam's tax-efficient funds will offer a better investment for shareholders who do not invest in a fund early on because of the plan to close a fund when the unrealized capital gains grow significantly, Present said.

Unrealized capital gains are, in essence, the paper profits a fund has earned on its investments. The gains represent the amount that the funds' assets have increased over their purchase price. When funds sell their appreciated securities, they must pass along the capital gains to investors, who pay taxes on the gains.

The new Pioneer Tax Managed Fund will have a value orientation. To minimize taxes, Pioneer plans to use such methods as avoiding the sale of stocks that have appreciated substantially in value and selling losing stocks to offset gains.